Chapter 6: Answers to Questions and Problems

1. When an input has well-defined and measurable quality characteristics and requires
specialized investments, the optimal procurement method is a contract. A contract
reduces the likelihood of opportunistic behavior and underinvestment by creating a
legal obligation between the firms. One disadvantage of a contract is that it increases
a firm’s transaction costs. An example, Boeing contracting with an aluminum
manufacturer.

2. When a firm requires a limited number of standardized inputs that are sold by many
firms in the marketplace, the optimal method of procurement is spot exchange. One
advantage of spot exchange is that they permit firms to specialize. A disadvantage is
that the firm may potentially face the hold-up problem. An example, a painter
purchasing paint from a local paint store.

3.
a. Contract.
b. Vertical Integration.
c. Spot exchange (or possibly contract if a specific investment in many motors is
required).
d. Spot exchange.

4. Engine manufacturing involves specific investments and a complex contracting

environment. By vertically integrating, the potential for opportunism is reduced.
Mirrors are relatively uniform products that can be purchased by spot exchange or
contract.

5.
a. Human capital.
b. Physical asset specificity; note that the assembly line was designed especially for
a particular firm’s product.
c. Site specificity.

6. The manager prefers the compensation scheme that pays a fixed salary plus a
percentage of the profits. Essentially, the manager is faced with a choice between two
consumption bundles: (1) a $125,000 fixed salary plus 10 hours of on-the-job leisure
and (2) $125,000 in salary plus bonus plus 3 hours of on-the-job leisure. Since the
original compensation package of a $125,000 and 10 hours of shirking is still
available, the fact that she chose to work 7 hours reveals that she prefers the second
pay scheme.

Managerial Economics and Business Strategy, 7e Page 1

7. Spot checks and hidden video cameras are effective and relatively inexpensive to
implement initially. The disadvantage is that spot checks and hidden video cameras
may affect the morale of the workers. Moreover, implementing hidden cameras
requires more employees to monitor the cameras. The advantage of pay for
performance schemes is that it may be easier for a managers to observe individual
worker (or group) performances. However, pay-for-performance schemes may be
costly. In addition, when output is a function of group performance or its quality is
difficult to measure, an individual’s contribution to the output may not be observable.

8.
a. Reduce the benefits of vertical integration.
b. Reduce the benefits of vertical integration and lead firms to use contracts or spot
exchange to procure inputs.
c. Lead to contracts that are more detailed or vertical integration.
d. Make spot exchange an unattractive method of procurement due to opportunism
and possibly underinvestment.
e. Make contracts a less attractive form of input acquisition.
f. Lead to longer contracts, or in extreme instances, vertical integration.

9.
a. When MC (L ) = 10 + 2 L , the optimal contract length is 20.
b. MC (L ) = 5 + 2 L , the optimal contract length is 22.5.
c. When the marginal cost curve increases, the optimal contract length increases.
When the marginal cost curve decreases, the optimal contract length decreases.

10.
a. When the MB = 100, the optimal contract length is 45.
b. When the MB = 150, the optimal contract length is 70.
c. Increases in the marginal benefit to writing a contract increase the contract length.
Decreases in the marginal benefit to writing a contract decrease the contract
length.

Page 2 Michael R. Baye